The unveiling of the UK fiscal budget brought attention back to the process of austerity, or deficit reductionâthe combination of lower spending and higher taxes. Under the current plan, budget cuts will persist for five years, and BCA Research estimates that austerity could reduce growth in the UK by roughly 1.5% in 2011 and 2012.
UK austerity includes:
- Slashing public sector payrolls by nearly 500,000 during five years.
- Reductions in low-income benefits, as well as police and prison funding.
- Another increase of the value-added-tax on retail spending, to 20%, in 2011.
- The top marginal tax rate for individuals increased to 50% in 2010.
Many nations' problems are too large to choose between spending reductions and raising taxes, and the growth rates required to solely grow out of problems are unrealistic in many cases. However, a recent study by the International Monetary Fund indicates that tax increases tend to be the most burdensome method, as they're a disincentive to growth.
Separately, spending cuts give markets confidence regarding government commitment to debt reduction. With the ability to provide fiscal stimulus hampered by large deficits, many countries have been adjusting monetary policy and currencies to boost growth.
Can every nation cheapen its currency?
A weak global recovery tempts every nation to lower its currency to make its goods less expensive, and thus more attractive to foreign buyers. Although officials may disagree, the United States is no exception.
The dollar has dominated the currency adjustment, falling as traders believe the Fed will be the most aggressive central bank to expand money supply. However, the "sell the US dollar" trade has become nearly Wall Street consensus, and there are few dollar bulls. As such, the dollar could experience a short-term bounce.
Additionally, other nations are fighting the dollar decline, as well as an undervalued Chinese yuan. Asian export nations such as South Korea and Japan have undertaken moves to weaken their currencies.
However, as currencies are relative, not every nation can weaken their currency. This increases the likelihood of protectionist measures, either through import tariffs or other trade barriers. Protectionist actions are a potential risk to the global recovery.
The US Congress is seeking to punish China for undervaluing the yuan. Meanwhile, the major source of the problemâan ongoing US trade deficitâwill likely remain, as long as US consumers (70% of the US economy) outspend the growth of US exporters (12% of the US economy).
Further arguing against an aggressive revaluation, a strong rise in the yuan is likely to only shift the source of US imports from China to other low-cost producers such as Vietnam, or to higher-cost locales, hurting US consumers.
China plans for the next five years; current growth still too hot
The Chinese government plans in five-year increments, with a new plan starting in 2011. The process and numerical details are slated to conclude in March, but expected changes include:
- A lower GDP growth target.
- Reduction in income inequality.
- Increased spending on social housing and safety nets.
- Improvements in sustainable energy use and supply.
The Chinese government wants to shift its economy away from export- and investment-led growth to domestic-oriented consumer demand. This shift is likely to take place over many years, but will likely include increasing consumer purchasing power through a higher currency.
The yuan should increase gradually, as a large adjustment would be disruptive. However, with growth still too fast, we expect that a rising yuan will be a tool that the Chinese government will use over the near term to slow the economy, in combination with raising interest rates.
Evidence that growth is still too hot:
- Third-quarter GDP growth of 9.6% year-over-year.
- Inflation heating up to 3.6% year-over-year in September.
- Vehicle sales up 17% year-over-year and 18% month over month in September.
- Property prices up 0.5% month-over-month in September.
It was just a few months ago that investors were worried that China's economy would slow too quickly, experiencing a hard landing. However, with growth still strong and the ability of the Chinese government to engineer another stimulus, a hard landing appears less likely.
This sentiment change resulted in strong foreign capital investment inflows to China during September. Combined with still ebullient sentiment domestically, the government is trying to reduce access to money, as well as expectations regarding inflation and property prices.
As such, since late September, the government implemented harsher measures to crack down on property speculation, raised interest rates, and has been rumored to have increased reserve requirements for six major banks
Improved Sentiment Regarding China
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Source: FactSet, Standard & Poor's, and the Shanghai Stock Exchange, as of October 27, 2010. Indexed to July 2, 2010 = 100.
Despite tightening measures and better-than-expected economic results, the Shanghai Composite has continued its bull run from the July 5 low, indicating worst-case scenarios were priced into the market. Stronger-than-expected growth in China is encouraging and could be a leading indicator of better sentiment regarding the global economy.
